I Wouldn't Touch These Banks With a Cheap CDS!

When Lehman Brothers went bankrupt, the entire financial system plunged into cardiac arrest. On Monday, one measure of European financial-sector risk was close to the same level it hit the day Lehman bit the dust. And if you think that's purely a European phenomenon, you're wrong: Similar signs are visible right here in the United States. Investors in financial shares need to be mindful.

Default risk has risen
The following table shows the increase in the cost of insuring the debt of four of the "too big to fail" banks over the past 28 days:

Source: Markit. Prices as of Feb. 1, 2010.

Investors are paying up for insurance on these financials' debt, indicating that the perceived risk of default has increased. Note that this has occurred even as the Obama administration has announced several major measures that are explicitly aimed at reducing the risk of large financials.

A legitimate guru on big bank stocks
CLSA strategist Christopher Wood, who predicted Japan's lost decade and the U.S. subprime crisis, cites two factors for his bearish outlook on European and U.S. financials in his Greed and Fear report. First, he expects the yield curve to flatten "when investors realize that the recovery in the West is not normal, and government bond yields, as a consequence, decline." This flattening will reduce the abnormal profits that banks are earning by borrowing short-term funds at zero and buying longer-dated securities.

Second, he thinks investors who are snapping up the shares of big banks aren't properly discounting the impact of looming regulatory change, "which at a very minimum is likely to mean structurally lower returns on equity." He continued, "This is because they are experts on finance, not politics."

Do valuations make sense?
According to data provided by S&P Indices, financials made up the best-performing sector in the S&P 500 from the March 9 market bottom through the end of 2009, with a 131% gain. Bank-share investors -- or prospective investors -- shouldn't let the euphoria of that result go to their head, though. Echoing Christopher Wood's warning, I recommend verifying that bank valuations still contain a margin of safety to account for financial and political risks. Alternatively, investors who are wedded to financials should consider regional and local banks as an alternative to politically toxic megabanks -- a conservative lender such as People's United Financial (NYSE: PBCT) can still be bought at book value, for example.

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